Inflation & erosion

Inflation will affect the price of absolutely anything that we buy, from dishwashers to doormats. If anyone can recall the price of petrol just 10 years ago, then you’ll be aware that it was 104p (pence) per litre on average across the U.K. Today that figure stands at 121.11p. That’s a rise of 16.45% in just ten years.

If we go back even further to 1995, then the price per litre was 54p. Therefore, during the subsequent 23 years, there has been an eye-watering 124.27% increase in fuel here in the U.K.! That’s a rise of 5.4% per year!

That tank of fuel costs much more today, thanks, in part, to the effect of inflation. This economics term refers to “the tendency of prices (for consumer goods, services, housing) to gradually rise over time”. Inflation also takes huge chunks out of your savings, especially in todays low interest rate environment, which makes it vital to understand inflation and its effects.

You may ask: “How does inflation affect my savings?”

Let’s begin with a hypothetical situation, whereby you have £100 in a savings account that pays a 1% interest rate. After a year, you will have £101 in your account. However, let’s also say that during this period inflation is running at 2%, therefore you would need to earn 2% on your savings just to break even. This is the impact of inflation, and the power that it has in eroding your money.

In the situation above, you will only have £101 in your account after a year, and so you have actually lost some purchasing power of that money. The reason for this is that the same items that cost £100, will now cost £102, however you only have £101 in your savings, and so you cannot purchase the items that you could have one year ago. Your money no longer has the same value.

If your savings don’t grow to reflect this rise in prices over time, the effect will be as though you are actually losing money.

Somewhat worryingly, a survey conducted by Nutmeg stated that of 1,000 investors who were interviewed, one in six people don’t know how to stop their money being eroded by inflation.
An article written by Holly Black and published in Moneywise during 2013 states that:

“Tony Stenning, head of UK retail at BlackRock, points out that savings could be more than halved in just 25 years if investors leave their money in cash. Research by the company found £100,000 would have the purchasing power of just £47,761 after 25 years and a massive £14,000 would be eroded away in just five years.”

It is evident that cash is no longer the risk-free asset that many U.K. savers perceive it to be. Instead, savers who are keeping their entire hoard in cash face huge dangers that – come retirement – there won’t be anywhere near the amounts that they require.

What causes inflation?

This is a very loose form of supply and demand. As the money supply in an economy rises, there is likely to be more demand from consumers looking to buy various goods. Think of rising populations with more people heading to Asda to buy their groceries. This rising demand creates a pressure on prices and they rise. As more people are willing to pay for these goods, sellers hike up their prices. Why wouldn’t they?

Inflation is measured here in the U.K through the Consumer Price Index (CPI). The CPI measures the price of a “basket” of 700 items which can be purchased from over 100,000 outlets across the country. By doing this on a monthly basis, the government is able to calculate the average increase of the same goods that an average consumer could purchase, and thus see the price increase or “inflation”.

On rare occasions the prices of these items could fall, and this is called deflation. I’ll cover this – and the equally damaging side-effects of it – in subsequent articles.

Safeguard your savings from inflation

So, back to the matter at hand and how you can protect yourself against inflation. Inflation is now starting to increase here in the U.K. and as of last month stood at a six-year high of 3.1%.

The good news is that there are ways of managing the situation. For people who are now retired and in receipt of their State Pension, fear not! The government very kindly increases the amount that you will receive, and so it is adjusted to take inflation into account.

If you’re still of working age, then there are also things that you can do to combat inflation. The first and most obvious of these is not to hold your entire savings in cash. The derisory amounts that high street banks offer in interest will in no way protect you from inflation.

As of this writing, the highest “easy access” savings account that I could find was through the AA, who are offering an annual rate of, wait for it…1.32%! Therefore, you can quickly see that even with this savings account, your purchasing power would decline by 1.78% in a single year. Not good.

Turn your savings into investments

As a general rule, your savings should be sufficient to cover all of your personal expenses, including your mortgage, loan payments, insurance costs, utility bills, food, and clothing expenses for at least six months. That way, if you lose your job, you’ll be able to have sufficient time to adjust your life in the search for a new income, without any additional pressure.

Any specific purpose in your life that will require a large amount of cash in five years or less should be savings-driven, not investment-driven. The stock market in the short-run can be extremely volatile, losing more than 50 percent of its value in a single year. Although these events are rare, they have occurred in the past and will almost certainly occur again in the future.

Stock market returns generally tend to beat cash alternatives, however many savers here in the U.K. are not comfortable with investing in the stock market. In this regard we are by no means as outwardly thinking as our American cousins. Maybe this is the British reticent persona, who knows.

Either way, the majority of British people frown upon the stock market, and see it as some form of financial piranha pit, whereby it’s impossible to unearth the next Apple, Amazon etc. The latter part of this comment I would certainly agree with, to the point whereby I own only one individual stock, with the majority of my wealth being in index funds.

What are index funds?

Index funds are a very low cost way to gain exposure to a wide variety of stocks. You will not be putting all of your eggs in one basket and will be protected against the volatility that individual stock selection will bring. This by no means ensures the safety of your capital, but over long periods of 10 years or more, an index fund will almost certainly beat cash.

In fact, Barclays publishes an annual Equity-Gilt study, which compares various kinds of investments every year since 1899. This study discovered that over rolling 10-year periods, shares have beaten cash 91% of the time. Over 18-year periods, that figure rises to 99%, and over 23-year periods shares have never once been beaten by cash — and in most periods, shares came out way ahead.

Should you wish to read more about the above study, then I’ve hosted the file here.

It is therefore evident to see the importance of holding a long-term view when thinking of your savings and investments. However, you should never invest in the stock markets on a one-year basis because short-term volatility can be high.

Final thoughts

Inflation refers to the increase in consumer prices in a given period of time, and this upward trend will gradually eat into the purchasing power of one’s money. Fortunately, there are ways to combat this, which are cheap and easily accessible to all.

I hope that this article has dispelled a few myths regarding investing, especially ones that exist here in the U.K.

As always, I would love to hear your thoughts and opinions regarding this subject, or if you think that there’s anything I may have missed here.

Alternatively, if you would like any topics covered then please leave a comment below, or email me directly, and I’ll endeavour to answer it for you!